International Financial Flows and Transactions Taxes
Survey and Options

Tobin has suggested that exchange rate volatility be controlled through a tax on international financial transactions. This analysis shows that the Tobin tax as a pure transaction tax is not viable. The tax would impair financial operations and create international liquidity problems. It is also unlikely to deter speculation. However, a possible alternative would be a two-tier rate structure—consisting of a low-rate transaction tax plus an exchange surcharge. The exchange rate could move freely within a “crawling” exchange rate band, but overshooting the band would trigger a tax on an “externality,” which is the discrepancy between the market exchange rate and the closest margin of the band. The scheme is inspired by the European Monetary System. However, exchange rates would be kept within the target range through a tax, not through interest policy or central bank sterilization and, eventually, the depletion of international reserves.

Abstract

Tobin has suggested that exchange rate volatility be controlled through a tax on international financial transactions. This analysis shows that the Tobin tax as a pure transaction tax is not viable. The tax would impair financial operations and create international liquidity problems. It is also unlikely to deter speculation. However, a possible alternative would be a two-tier rate structure—consisting of a low-rate transaction tax plus an exchange surcharge. The exchange rate could move freely within a “crawling” exchange rate band, but overshooting the band would trigger a tax on an “externality,” which is the discrepancy between the market exchange rate and the closest margin of the band. The scheme is inspired by the European Monetary System. However, exchange rates would be kept within the target range through a tax, not through interest policy or central bank sterilization and, eventually, the depletion of international reserves.

I. Introduction

The liberalization of international capital markets and flexible exchange rates were once hailed by economists as a panacea to the ills of the Bretton Woods system with its intrinsic contradictions and inherent instability that Triffin had denounced so vociferously.2/ OECD countries have pursued the former goal persistently since 1961 (when they adopted the Liberalization of Capital Movements Code 3/); this objective is still cherished as promoting the efficiency of world capital markets. The goal was essentially achieved in the Western world by the beginning of the 1990s, yet progress is also visible in the developing and in the former communist countries. However, the flexible exchange rate regime that replaced the fixed-parity Bretton Woods system in the early 1970s has subsequently generated significant medium- and short-term price fluctuations that have refuted the extravagant claims of some advocates of floating rates that national monetary policies could proceed without external concerns, leaving the currency markets to reconcile the policies and macroeconomic performances of the several economies. On repeated occasions, international financial markets have encountered strong turbulence that has irritated market participants and policymakers and has instigated interventionist attitudes toward these markets. Exchange rate and interest rate volatilities have fostered fixed rate (and gold standard) nostalgia and aroused debates on the need for international policy coordination and supranational surveillance in order to control such fluctuations and to lessen market uncertainties.

One concept of stabilizing international flows of funds is macroeconomic policy coordination, which has proven extremely difficult to accomplish. The European Union (EU) is heading for the irrevocable fixing of member countries’ currency rates (and ultimately a uniform currency) under a different approach that counts on macroeconomic policy convergence through statistical guidelines. In a similar vein, other countries, in particular the developing, have tried to discipline and coordinate their policies by aligning their exchanges rates to foreign “anchor” currencies either unilaterally (e.g., Mexico, Argentina) or backed by bilateral agreement (e.g., CFA countries). However, all forms of policy coordination have not fully achieved their objective of stabilizing exchange rates and it may weigh heavily in terms of lost national sovereignty in monetary and fiscal policies.

Recent turbulence in exchange markets has rekindled interest 4/ in a proposal by Tobin, who suggests that speculative international capital movements and exchange rate fluctuations could be controlled by imposing a tax on international financial transactions (Tobin (1978, 1991); see also Eichengreen, Tobin and Wyplosz (1995)). The tax would reduce noise from market trading, but allow traders to react freely to changes in economic fundamentals and policy. It would constitute a “soft” approach to controlling foreign exchange markets in contrast to more radical interventions like capital controls and other protective devices. It would thus avoid the risks of political counteraction to “hard” protectionist measures that could set off self-defeating beggar-thy-neighbor reactions in the world economy. The tax would enhance market efficiency and be consistent with efforts to coordinate national policies at the international level. Furthermore, it could work under both flexible and fixed exchange rate regimes. Finally, the tax could serve as a policy instrument at the disposal of an international organization like the IMF and contribute to enhancing global financial stability.

II. The Nature of the Tobin Tax

The idea to contain speculation in financial markets by rendering access more expensive through a transactions tax goes back to Keynes (1936). Keynes compared speculative activities to casino operations and argued that “…casinos should, in the public interest, be inaccessible and expensive” (p. 159). Tobin translates this idea into foreign exchange markets 5/ where he wants to throw “sand in the wheels” in the form of financial transactions taxes. More specifically, Tobin suggests “an internationally uniform tax on all spot conversions of one currency into another, proportional to the size of the transaction” (Tobin (1978), p. 490). He suggests that a 1 percent rate could be appropriate. 6/

The tax would be payable every time a currency is converted. This renders frequent short-run trading much more costly than long-term capital engagements, and this must reduce the volume of short-term flows of funds. Tobin asserts that it would thus contain erratic exchange rate volatility. 7/ As the Tobin tax raises the costs of currency trading inversely to the maturity of the asset, it would “direct traders’ attention to long-run fundamentals and away from transient contagious market sentiment.” (Tobin (1991), p. 16). The idea is to check short-term capital movements, and not to impede commodity trade or longer-term international investment.

The main advantage of the Tobin tax is indeed that it can target short-term financial transactions very effectively. The differential impact of the Tobin tax on short-term and long-term trading is specified arithmetically in Appendix 1. The formula allows the calculation of annualized interest rates on foreign investments that are needed to match a target interest rate in domestic currency. If this target rate is 4 percent for a domestic asset and the Tobin tax is 0.5 percent (1 percent) of the foreign exchange transaction, the following foreign interest rates are required to fulfill the arbitrage condition between markets:

Table 1 demonstrates that a Tobin tax discriminates against all foreign assets, but long-term capital investment requires only a slightly higher rate of return than domestic assets. The discrepancy becomes smaller as the maturity of the foreign investment increases. Moreover, the additional cost of foreign investment may be outweighed by gains of exchange rate stability and certainty. Exchange rate adjustments responding to a medium-term change in market fundamentals would thus not be impeded by the tax to any significant degree. However, short-term trading bears high relative costs, and speculative round-trip excursions in other currencies are likely to be heavily discouraged by the Tobin tax. According to Tobin, this would remove excessive short-run volatility of exchange rates, and monetary policies would regain a degree of freedom that is lost under the pressure to counteract short-run fluctuations.

Table 1.

Annualized Foreign Interest Rate Required Under a Tobin Tax to Match a 4 Percent Return in Home Currency

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Source: Staff calculations (see Appendix 1 for the methodology).

Ideally, Tobin wants to exclude from tax all foreign exchange transactions related to the real flow of goods and services as well as to fixed capital formation. He is skeptical, however, that this can be achieved technically, fearing that financial transactions could then be “disguised as trade” (Tobin (1978), p. 494). Therefore, all financial transactions should bear the tax without exception. The cost for direct investments would become smaller with the duration of the engagement anyway, and payments for goods and services would be partly relieved as the tax is levied only once (instead of twice, as in the case of financial round-trip transactions). One would want to add that firms, in particular international firms, could organize their payments in a way as to minimize the tax through the netting of credits and debits in one currency (which is market-neutral). 8/

The Tobin tax, contrary to other financial transaction taxes proposed in the literature or applied in practice, is a truly international tax. The world tax rate would have to be uniform to avoid many of the locational distortions discussed in the context of national transactions taxes. However, the tax would be administered by national governments over their own jurisdictions even when domestic currencies are not involved (e.g., the British government for Eurodollar transactions in London). The proceeds of the tax could “appropriately be paid into the IMF or World Bank” (Tobin (1978), p. 494). The responsible organization would also coordinate policy regarding the Tobin tax at the international level.

III. The Tobin Tax in the Literature

1. General aspects

The Tobin tax—only outlined by Tobin himself—has received relatively little attention in the literature. 9/ However, financial transactions taxes, in particular a securities transactions tax (STT), have been studied more intensively, notably in the context of proposals to introduce an STT in the United States under the Bush and Clinton administrations. 10/ Moreover, where the Tobin tax is discussed in the literature, very different objectives come into play, and the term “Tobin tax” often stands for something quite distinct from the original proposal.

The following objectives of financial transactions taxes other than exchange rate stabilization can be distinguished.

Surrogate taxation of capital income. Since the transactions tax increases the cost of capital worldwide, it is tantamount to a surrogate tax on capital income. It could thus compensate for tax revenue lost through evasion as it becomes increasingly more difficult to tax capital under national personal and corporate income taxes (Grandcolas (1986)). The tax can also be seen as a tax on a specific type of financial services that is difficult to tax under a general turnover or value-added tax. Proponents of this view would, of course, extend the tax to all financial transactions, national and international. However, a tax on international capital transactions would also be borne, to some extent, by domestic investors as capital is diverted from international to national markets, forcing interest rates down within the domestic economy.

Taxation and quarantining of tax havens. A financial transactions tax could be used to impose a heavier burden (e.g., through a higher rate) on capital outflows and inflows to and from tax havens. This would not only work as a presumptive tax on “illegal” capital flows to offshore markets, it would also cut off financial markets that are unwilling to cooperate at the international level. It would not prevent circular flows of existing capital within offshore centers, nor would it be possible to tax offshore capital ex post. But, given the increase in the value of world financial transactions, the importance of offshore markets would decline in relative terms, which should bring them to the negotiating table in the longer run. Circular flows within insulated offshore markets would leave exchange rate developments unaffected anyway.

Increasing the efficiency of the financial sector. Many authors, including Tobin, affirm that “vast resources of intelligence and enterprise are wasted in financial speculation, essentially in playing zero-sum games” (Tobin (1991), p. 18). 11/ A financial transactions tax could eliminate “wasteful” trading and “excessive financial engineering” (Summers and Summers (1990), p. 881). This would contribute to a more efficient allocation of resources. If this is not the case, the Tobin tax could at least produce government revenue without critical negative side effects (Stiglitz (1989)).

Elimination of the irreversibility distortion against fixed capital formation. Although economic fundamentals may be sound, investors often prefer to hold capital in liquid form. They refuse to engage in real projects although such projects are more profitable than financial assets, and investors willingly pay a significant premium in terms of opportunity costs. This paradox is explained by policy uncertainty, which is characteristic for many developing countries. In the presence of uncertainties, it may pay to remain liquid since real capital formation is irreversible and policy mistakes can quickly erode its economic returns. This short-term perspective of investors prevails even during episodes of reversed capital flight, and it encourages the inefficient round-tripping of capital. It is demonstrated that a sequence of taxes on international financial transactions could eliminate underinvestment by reducing the volatility of domestic interest rates (Tornell (1990); his arguments are sketched in Appendix 2). More generally, a transactions tax would cause investors to focus on longer-term prospects (Summers and Summers (1990), p. 882).

2. Specific contributions

This section comments briefly on specific variants of the Tobin tax as found in the literature. The variants are described more fully in Appendix 2. Some of the most important characteristics of various variants of the Tobin tax are summarized in Table 2.

Table 2.

Characteristics of Variants of the Tobin Tax

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Source: Staff compilation.

Reinhart (1991) examines a Tobin tax in the context of a general equilibrium model of exchange rate determination for a small open economy under rational expectations. He applies the tax to the domestic stock of foreign assets, not the flows of foreign exchange transacted, and argues that the tax increases the opportunity costs of holding foreign assets, causing investors to shift into home assets. The repatriation of capital entails a transitory appreciation of the exchange rate and a deterioration of the country’s trade balance. This appreciation of the currency is followed by a real depreciation as the holdings of foreign assets approach their equilibrium value and the gap in the trade balance is closed. An implicit result of Reinhart’s exercise is that a decumulation of foreign assets also affects the net real interest rate for holdings of domestic assets over time. Thus, the tax works as a surrogate capital income tax. Reinhart’s variant of the Tobin tax bears resemblance to the real interest equalization tax (RIET) proposed, for instance, by Liviatan (1980) and Dornbusch (1986a and 1986b).

Tornell (1988 and 1990) demonstrates that a tax on international transactions can eliminate the expectation of short-run interest rate volatility, and hence uncertainty. This reduces shortsighted investment behavior, and fosters real over financial capital formation. Tornell’s tax base is an expectational variable rather than a straightforward spot transaction. However, the author asserts that the tax “can be implemented through a dual exchange rate system” (Tornell (1988), p.13). Tornell’s contribution draws attention to the fact that an optimal Tobin tax would either have to be applied to a varying tax base (like the one proposed by Tornell), or the tax rate on effective market transactions would have to change over time.

Eichengreen and Wyplosz (1993, p. 120) also discuss a Tobin tax on foreign exchange transactions that is, however, implicit rather than explicit. The “tax” would result from the requirement of banks to “deposit a sum equivalent to the transaction [in foreign exchange], interest free, with [the Central Bank] for one year” (emphasis added). Their proposal has been substantially refined in Eichengreen, Rose and Wyplosz (1994) and Eichengreen, Tobin and Wyplosz (1995). A similar alternative is mentioned in UNCTAD (1994, p. 112) where non-interest-bearing deposits corresponding to increases in open positions in foreign exchange are discussed. The implicit tax rate corresponds to the opportunity costs of holding these mandatory funds. The proposals are similar to the Tornell tax to the extent that variations of the expected return of financial assets in home and foreign currencies are reflected in an interest rate differential.

IV. Tax Policy Issues

1. Fiscal versus monetary policies

Examination of the literature on Tobin taxes illustrates a wide spectrum of reactions to the original proposition. It also bears testimony of the profession’s predilection for monetary rather than fiscal solutions as proposed, for instance, by Tornell (1988 and 1990), Eichengreen and Wyplosz (1993), Eichengreen, Tobin and Wyplosz (1995), and, to the extent that a preference is detectable, in UNCTAD (1994). It is clear that there is an option between fiscal and monetary policy measures. Furthermore, there is the general belief in the market’s ability to generate exchange rate stability without policy interference.

As to the latter view, Tornell remains in the tradition of the optimist monetarist literature that follows Friedman (1956) in maintaining that no professional case can be made to the effect that speculation is destabilizing, and which holds that the current equilibrium exchange rate correctly reflects the anticipated path of future (exogenous) money. This view supports a noninterventionist attitude vis-à-vis foreign exchange markets because flexible exchange rates would ultimately be self-stabilizing.

Experience has shown, however, that exchange rate volatility can be substantial under floating rate regimes, and Tobin himself (1978, pp. 155ff) reviews a number of reasons why market forces alone are unlikely to stabilize exchange rates even when flexible—at least in the short run. The main points can, perhaps, be summarized in a statement by Dornbusch who purports “that there is an exchange rate indeterminacy because financial policies, which supposedly anchor the system, are in fact endogenous and may be substantially caused by movements in the exchange rate” (Dornbusch (1986a), p. 32 (emphasis added)).

Nevertheless, Tornell seems to believe that the exchange rate mechanism provides an indicator for variations of the expected return of financial assets which is, however, biased through the transactions motivated by trade and the formation of real assets. For this reason, he champions the detachment of financial markets from market inertia resulting from commercial transactions: 12/ “If the financial exchange rate is freely floating, [then expectations are correctly reflected in the financial exchange rate]. Therefore, a dual exchange rate system acts as a sequence of continuously adjusting Tobin taxes.” (Tornell (1988), p. 24 (emphasis and text in brackets added)). His view is confirmed by Adams and Greenwood (1985), who prove that a dual exchange rate regime is indeed equivalent to levying a tariff on international financial transactions.

Dual exchange rate regimes have been tried by various Latin American countries (and by Belgium, until recently). They seem to require formidable institutional arrangements to keep markets segregated and to avoid financial arbitrage. Such arrangements foster the evolution of an ever-increasing web of “state interventionism.” They are also susceptible to the creation of new distortions (e.g., through failure to fix the equilibrium exchange rate for commercial trade), and they spur the emergence of multiple exchange rate regimes and of “black markets.” There are unlikely to be consistent with GATT rules or the Maastricht Treaty of the EU, and they are certainly at odds with the OECD Liberalization of Capital Movements Code. It can be demonstrated that there is an equivalence between dual exchange rates and capital controls (Adams and Greenwood (1985)). Dual exchange rates are, thus, a form of protectionism.

Although the volatility of financial exchange rates, combined with a more stable commercial rate, may convey more information to speculators than the effective exchange rate of unsegmented markets, it is doubtful whether this is sufficient to remove the indeterminacy problem invoked by Dornbusch (see quote on page 8). It is also arguable whether the “freed” financial exchange rate would differ much from the effective rate of dual exchange rate schemes given the fact that today’s capital transactions dwarf the volume of commercially motivated transactions. Tobin remains skeptical in this regard: “Increasing exchange risks will help, but I do not think we should expect too much from it” (Tobin (1978), p. 158).

Eichengreen and Wyplosz (1993) consider a monetary policy action equivalent to the fiscal proposition of Tobin. The analytics of this “tax” are unclear, however, depending largely on the definition of the tax base and on the interactions of the implicit tax with related monetary policy measures. Obviously, there may be an equivalence between fiscal and monetary policy measures. For instance, a tax on foreign financial assets could have the same effect as an interest rate subsidy on domestic deposits.

The advantage of monetary policy measures seems to lie in the possibility to inflict costs (or, through subsidies, opportunity costs) on national and international investors unilaterally, without necessarily coordinating policies at the international level. This represents a considerable advantage during phases of great turbulence. On top of classical sterilization policies, countries have developed an arsenal of monetary defense instruments such as higher reserve requirements or negative interest rates on nonresidents’ deposits (Chile, Malaysia, Spain, Switzerland) or, conversely, high overnight deposit rates (Sweden, Ireland). They have tried to limit banks’ liabilities in foreign currencies (Mexico) or of portfolio investments by nonresidents (China, South Korea), and they tend to exclude nonresidents from certain markets and operations including outright bans on investment by foreigners (Swiss property market, parts of China’s stock market). This has not prevented some of these countries’ currencies to come under speculative attacks. It can even be argued that such interventions, especially if temporary, could just as well encourage speculation to the extent that they send negative signals to financial markets, namely: distress and the lack of international coordination. This could provoke nervous reactions of market participants and drive even the sedate investor into speculation. Such measures also encourage “moral hazard” to the extent they raise expectations of a bailout by central banks. If unilateral monetary policy measures are more permanent, however, they tend to fend off international direct investors, with long-term implications for growth and the development of the economy.

Equally, some countries have employed fiscal instruments unilaterally. 13/ Many have charged (or charge) financial transactions, generally or specifically, through stamp and coupon taxes (for example, Germany, Sweden, Switzerland, the United Kingdom), they taxed capital inflows (Israel), charged outward-bound capital transactions (Interest Equalization Tax in the United States), or tried to discriminate against foreign financial investments through taxes on bank assets and withholding taxes (Germany, Switzerland). 14/ Many of these measures appear to hamper the natural development of financial markets, institutions, and operations; they encourage tax-evading detours through ancillary financial centers and tax havens; to the extent they are effective they invite retaliation, and they are unsuitable to cope with sudden transient monetary shocks, because, as a rule, tax policy seems to face much longer reaction and implementation lags than monetary policy. These may be reasons why they have been recently eliminated in many countries (e.g., Australia, Germany, Sweden).

Fiscal policy measures could, however, eventually become more propitious for market developments if adopted multilaterally. International coverage and enforcement are important aspects of the Tobin tax. It reduces the scope for evasion, it could be more abiding, and it could eventually avoid the ad hoc aspects of unilateral monetary defense schemes. Multilateral fiscal policy schemes, of course, need international agreements and cooperation. However, the prospects for multilateral fiscal consensus seem to be more propitious than for monetary policy actions because the latter are usually seen as an unwarranted bailout of weaker currencies, with severe moral hazards for general economic policies. This is not the case for coordinated international taxation.

2. Financial market efficiency and stability

A tax on financial transactions—whatever its objectives—is subject to one cardinal premise: it must preserve financial market efficiency and stability. It is thus essential to discuss how international financial markets would react to the impact of a possible Tobin tax.

3. Transaction costs

Financial markets—domestic and international—have undergone dramatic changes during the last two decades. These are attributable to the break-up of overly restrictive banking regulations (especially in the United States), to the need to cope with inflation and the increase in international liquidity (following the oil crises of the 1970s), to the necessity of financing larger government deficits (in the United States and, more recently, Germany), and to the need to hedge against new risks ascribed to higher interest and exchange rate volatility following the demise of the Bretton Woods system. These developments have been spurred by significant technological advances in computing and telecommunication technologies through the creation of new financial instruments and product innovation, the diversification and the deepening of markets spawned by large institutional investors, and greater competition at the world level.

Today the reallocation of funds is effected in a matter of minutes or seconds, developed forward and options markets allow to hedge financial risks, and information is disseminated to market participants through fast and extensive electronic telecommunication networks that cover all major financial centers of the world. These developments have significantly enhanced financial market efficiency and reduced the relative costs of financial transactions and of foreign exchange operations in particular. They have further stimulated market activity and increased the volume of trade which, for foreign exchange transactions, may now have passed the level of US$1 trillion per business day. 15/

Although it is difficult to estimate the effective decrease in transaction costs over the last two decades, 16/ some authors contend that a transaction tax of 1 percent would still keep costs well below the levels that prevailed some 15 or 20 years ago (Hakkio (1994)). It is, however, misleading to compare the direct costs of foreign exchange transactions over the years as this is strongly dependent on the use of vehicle currencies. Originally, international traders and investors used the U.S. dollar almost exclusively as vehicle currency which avoided conversion costs altogether. Offshore dollar markets (like the unregulated Eurodollar market) were developed which became extremely liquid and cost effective. The U.S. dollar still dominates international transactions, although new vehicle currencies have emerged and regional currency markets have been developed with falling transaction costs. However, smaller currencies, if used at all at the international level, still have to “pass through” major currencies in the Eurodollar market, since bilateral exchange markets of nonvehicle currencies are too narrow and would entail higher transaction costs than a triangular arrangement using vehicle currencies as an intermediary. A Tobin tax thus discriminates against smaller currencies, because it penalizes triangular operations through double taxation. It would also promote the further use of vehicle currencies and restrengthen, in particular, the role of the U.S. dollar in world financial markets. 17/

Transaction costs have also been reduced by product innovation and by the creation of derivative financial instruments that allow individual investors to hedge against market risks while engaging only little capital (outright forward and futures transactions, swaps, and options). These instruments are of special importance for financial intermediaries, who have to protect themselves against interest rate risks, exchange rate risks, and credit risks, and who close open positions by buying or selling derivatives. Apart from rendering markets more liquid and reducing transaction costs, these instruments have become of utmost importance to the stability of the financial system as a whole.

a. Liquidity

Large institutional investors routinely engage in short-term arbitrage transactions for margins as little as 3 to 5 basis points on highly liquid transactions (like a US-dollar-DM swap)18/. This is important for the efficient fixing of prices in financial markets, and for the securing of worldwide liquidity. This type of liquidity trading constitutes the overwhelming part of financial transactions on a recurrent basis and it is vital for well-functioning financial markets.

A Tobin tax has the enormous disadvantage that it cannot distinguish between liquidity trading and speculation. Sound interbank transactions would thus be affected indiscriminately by the tax although they are non-speculative in nature. This, according to some authors, must lead to thinner markets with less liquidity, which could even increase volatility. 19/ The introduction of a Tobin tax could also cause a severe liquidity shock with large disturbances on a global scale. Moreover, the tax would lead to larger bid-asked spreads because market makers need to be compensated for higher risks and for the tying up of larger currency positions that are associated with reduced liquidity. 20/ Finally, the taxation of derivatives could seriously distort markets and undermine the financial sector’s ability to hedge against risks.

Some authors insist, however, that a small transactions tax would not reduce liquidity trading significantly, but eliminate destabilizing noise trading instead (Summers and Summers (1990)). This would reduce the discount rate for future transaction costs, due to the reduction of currency risks, and it would be beneficial for financial markets over the longer run.

The reference to noise traders reflects a “new strand of the finance literature” which “has developed the perspective that the financial markets may not be as efficient as previously thought” (Kiefer (1990), p. 889). Noise traders act, in contrast to informed “rational” traders, on misinformation like “technical investment analyses” or “rumors,” a behavior that may drive prices away from their fundamental equilibrium value and render markets riskier and more volatile (Shliefer and Summers 1990). Informed traders cannot counterbalance these destabilizing tendencies because price discrepancies may in fact grow as a consequence of noise trading (DeLong, Shliefer, Summers, and Waldmann (1988), Summers and Summers (1989)). The Tobin tax would reduce this type of trading and thus improve market efficiency. Although the argument seems convincing, the market-inefficiency thesis is not yet the accepted paradigm in the finance literature, and it has to be considered with caution.

As to the liquidity-shock thesis, the outright closing of the market could be viewed as a severe disturbance or an extreme case of a prohibitive tax (Stiglitz (1989), p. 111). However, French and Roll (1986) provide evidence for the U.S. stock market that whenever markets were closed for a day for technical reasons, trading resumed normally, the liquidity of markets was not impaired, and price volatility was even greatly reduced—not increased. 21/ This would make a case for a financial transactions tax.

As to the relationship between bid-asked spreads and liquidity, Black (1991, p. 514) demonstrates that the spread is indeed positively related to the ratio of price volatility to the volume of trade. However, Stiglitz (1989) argues that the tax could eventually lead to smaller spreads as holding periods of financial positions have nowadays become trifling, probably only minutes, and as volatility is being reduced through the tax.

With regard to the taxation of derivatives, however, the Tobin tax would positively face particular problems which, as above mentioned, could eventually entail the pure and simple elimination of such markets. Much depends on the level of the tax rate, however. The critical issues relating to the taxation of derivatives are more fully addressed in Section V.

b. Volatility

Excessive price volatility of financial markets is often ascribed to insufficient short-term speculation. In certain markets (real estate, art) significant mispricing can be identified, and significant price volatility is observed despite high transaction costs (Shiller (1990)). This can eventually be explained by these markets being rather illiquid (Summers and Summers (1989), p. 268), thus the lack of liquidity could be related to short-term price volatility. However, it does not follow that the increase of liquidity is always price stabilizing. Once a certain level of liquidity is attained, excessive liquidity could become destabilizing.

If there is a relationship between liquidity and price stability, this must emphasize the role of liquidity traders in the market. A Tobin tax would, however, discourage stabilizing arbitrageurs who will refrain from trading until the price varies from “true” value by more than the tax rate. “With the tax in place, arbitrage investors would wait for larger price discrepancies before entering the market” (Kiefer (1990), p. 891). If the tax reduces the volume of trading, markets become less liquid, and this could become the cause of greater volatility. Prices would move in jumps to close gaps that would not have emerged under normal trading operations—like intensifying geological tensions are relieved in an earthquake. 22/ The opposite view is, again, taken by those who believe that the tax only reduces noise trading and hence volatility.

Empirical evidence on the issue is scarce: For securities trading, Roll (1989) finds no significant relationship between volatility and transactions taxes. Furthermore, Kiefer (1990) suggests that average transaction costs (commissions, etc.) have fallen significantly for large institutional investors in the U.S. stock market while they may have risen for smaller investors. Since institutional investors are the dominant traders in stock markets, volatility should have increased as a consequence of the cost reduction. But stock market volatility in the United States exhibits no trend over the last 15 years (Schwert (1990)). Furthermore, Roll (1989) observes that, during the stock market crash of 1987, stock prices declined by similar (or even greater) proportions in countries with a securities transactions tax. This would indicate greater volatility for markets where transactions taxes are present, yet the argument is not fully convincing because it neglects institutional aspects and spatial differences in the liquidity of markets. 23/

A low tax rate would probably have little effect on volatility, given that large price fluctuations were observed in the early 1980s even though transaction costs of foreign exchange markets were much higher at the time than now. Under a low tax rate, liquidity could eventually be preserved, but the tax would miss its goal of removing short-term noise trading. The argument that “throwing in some sand” to reduce liquidity and hence volatility—the key argument on which proponents of the Tobin tax base their policy recommendations—thus rests on shaky theoretical and empirical grounds.

c. Resource allocation and tax incidence

The effects of a Tobin tax on the real economy are essentially dealt with in Section 2 in connection with Reinhart’s variant of the tax, which is more fully discussed in Appendix 2. Therefore, this section can be brief.

Positive economic effects of the tax are associated with its reducing “short-termism” (Reinhart 1991). The tax would lessen short-term trading (e.g., by institutional investors who face a higher relative increase in transaction costs) and markets would guide capital more reliably on the basis of fundamentals. The argument applies in particular to foreign exchange markets where significant risks of policy change may result from the behavior of myopic policymakers. The argument is not fully appropriate under all circumstances, however. Institutional investors (like Japanese insurance companies) are typically free from short-term considerations and usually invest with a longer-run perspective. 24/ They also prefer liquidity-risk-free vehicle currencies, which constitutes a problem of access to international capital markets for the less developed countries and for smaller currency areas.

Also on the positive side, a Tobin tax could eventually reduce “waste” in the financial industry related to “financial engineering,” and to unproductive rent-seeking activities (Tobin (1984), Stiglitz (1989), Summers and Summers (1989)).

A negative jolt of the tax could stem from its increasing the user costs of capital. While it could become a convenient form to tax capital income (respectively, turnover or value added of the financial sector) in view of certain shortcomings of the income and value-added taxes, it is also clear that such presumptive taxation could entail important deadweight costs. Most of this concern is, of course, related to the unilateral use of transactions taxes with its tendency to drive financial operations offshore. 25/ Such arguments are disregarded here, because the Tobin tax is supposedly a truly international tax that cannot be avoided through the inefficient rerouting of capital. 26/

With reference to the U.S. securities markets, Hubbard (1993) believes that deadweight costs of a securities transactions tax (STT) would be important. He argues that these costs could be even greater than indicated by their impact on the information content of market prices. “An increase in transactions costs discourages the use of financial markets to smooth consumption in response to idiosyncratic income fluctuations, increasing the variability of consumption and reducing individual well being… Moreover, with aggregate uncertainty, the greater idiosyncratic volatility in consumption reduces individuals’ willingness to bear aggregate uncertainty, increasing the required rate of return on equity relative to risk-free debt” (Hubbard (1993), p.995). 27/

Other authors are more impartial on the issue. They stress that the discounted value of the tax will fall with the holding period, and that risk premia will decline with reduced volatility. This would compensate for the higher liquidity risk. Also, risk-adjusted rates would move back to equilibrium over the longer run. Especially if the tax rate were small, the deadweight loss could be discarded, as it would be only proportional to the square of the tax rate. A tax at a rate of 1 percent would thus entail only negligible distortions (Stiglitz (1989), p. 104).

For the Tobin tax, the effect is tempered by the fact that only foreign exchange transactions are taxed, not financial transactions in general. Furthermore, the argument is based on the assumption that a fixed after-tax rate of return is demanded by the providers of international capital. This is not true where international investors can reap “excess profits” by going abroad. Excess profits can be taxed without causing deadweight loss. Also, the argument assumes that the supply of capital is infinitely elastic. This is typically not the case for international capital. Any realistic elasticity of savings would shift the burden of the tax partly onto savers. Finally, the argument does not take into account the use of the proceeds from tax by governments. If they are used to reduce public borrowing, this would increase capital market funds available to the private sector, and thus reduce capital costs. 28/

The distributional effects of a transactions tax are, of course, particularly difficult to assess. While the formal incidence seems to rest on financial traders and institutions, the effective incidence is typically on the real sector of the economy. However, it is nearly impossible to derive a precise incidence pattern for a financial transactions tax, which represents costs of financial intermediation that are ultimately borne by producers and consumers, with unknown supply and demand elasticities. Furthermore, short-term and long-term distributional effects would have to be distinguished. And the issue is further blurred by the international character of the Tobin tax.

However, the Reinhart model identifies an initial effect of the tax on prices of capital goods. Capital would be shifted into domestic assets, and prices of these assets would rise, which would render the holders of these assets wealthier. But, the small country is constrained by the level of world interest rates, thus net returns on foreign investments would fall and the repatriation of foreign capital would also lower the net rate of return on domestic investments. In the long run, the tax is spread on capital more generally. It would then become a surrogate capital income tax.

Also, the tax would probably discriminate against smaller capital-importing countries in the first instance. This would be true to the extent that their access to international capital markets was more difficult, which would facilitate the forward shifting of the tax onto issuer of debt from such countries. 29/ The situation would become even worse if the government of such countries furnished a large share of securities to the market—because governments might feel less constrained by their budgets and would be willing to bear the tax more readily. 30/ It would shift the international tax onto the taxpayers of smaller countries with external public debt.

The tax could also be inequitable between generations because pension funds—which represent a large share of the market—would probably bear an important share of tax. This would be true to the extent that they relied on financial institutions for their investment policies, and the need to diversify large blocks of capital bestowed financial intermediaries with a relatively strong position in the market, which would allow the backward shifting of the tax. Older and retired generations would then have to shoulder the tax. Since it is probable that foreign assets of institutional investors would be held predominantly on behalf of middle-income individuals and families, this could shift the burden of the tax primarily on these social groups (Hubbard (1993), p. 993). However, as the effective tax on long-term capital formation is smaller than on short-run transactions, the overall burden should be relatively small for such groups of investors. The incidence of taxes on short-term capital is, however, nearly impossible to assess.

V. Issues of Tax Design: The Four Dilemmas of the Tobin Tax

This section looks into four design problems the Tobin tax might face at the implementation stage—defining the tax base, the rate, revenue, and tax assignment.

The first three problems could be solved by remodeling the Tobin tax into a two-tier structure, which is further explained in Section VII. The fourth, tax assignment, has important political implications and can only be solved through negotiation and policy coordination at the international level if the tax becomes a multilateral scheme. However, it is conceivable that the remodeled Tobin tax would also work as a unilateral device, thus avoiding the problems of international policy coordination.

1. The tax base

The tax base of an international financial transactions tax should be as broad as possible, to limit tax avoidance and financial market distortions. Moreover, no group of market participants should be excluded a priori from paying the tax. The possibilities for substituting financial products are unlimited, and financial markets are particularly innovative in exploiting tax loopholes by shifting operations to untaxed institutions or creating new financial instruments not subject to tax. Nevertheless, special considerations must be given to both taxable trades and taxable transactions under a Tobin tax.

a. Taxable traders

Obviously, all foreign currency transactions would be taxable irrespective of the type of operations the trader or a trading institution normally engages in. It would equally apply to transactions effected by financial institutions, government and international organizations, the producers of goods and services, commercial enterprises, and private households. There would be no room for personal exemptions, and the nationality of traders would be irrelevant.

There are, however, deviations from this rule. Exemptions should reasonably apply to market interventions by monetary authorities to the extent that their own currencies are involved. This would allow effective monetary policies for stabilizing exchange rates. The tax could also exempt conversions of a vehicle currency into national currencies issued by a currency board. The same could be true for currency conversions subject to bilateral currency support agreements (CFA franc) or—in the future—between currencies of the European Monetary Union as long as a single currency is not yet in place. Eventually, capital transactions between governments and international organizations as well as official government aid to less developed countries could also be exempt from tax, although the case is more difficult to make and rests presumably only on merit grounds. The risk that these channels of foreign exchange transactions will be abused by speculators is, however, remote.

Although the tax base should be as broad as possible, political pressure will likely be exerted to exempt certain groups of traders from the tax. It could be argued, for instance, that market makers play an important public role in setting prices and stabilizing foreign exchange markets on a regular basis (especially for intra day trading), possibly even more so than central banks through their money market interventions. Indeed, market makers are typically not noise traders. It is therefore logical to ask for their dispensation from paying the tax. Likewise, it could be argued that most intermediary transactions involving financial institutions serve to secure the liquidity of the banking industry as a whole, and that the liquidity trading of banks should thus also be tax exempt. Another rationale would be that financial institutions also engage in normal nonspeculative business whenever they trade to hedge foreign exchange positions, or when they purchase currencies, for example, to meet delivery obligations following the exercise on a foreign exchange option. Most transactions between financial institutions are thus “intermediary” in a strict sense, and ideally should not bear the tax. This is particularly obvious for institutions with a pure “clearing” function. The case can therefore be made for exempting all financial intermediaries from the tax.

These arguments illustrate the first problem—defining the Tobin tax base. The dilemma stems from the impossibility to discriminate, on an institutional basis, between normal trading, which secures the efficiency and stability of financial markets, and noise trading, which is in fact destabilizing and should be the only target of the tax. To contain speculative trading, the tax has to be applied to all foreign exchange transactions, whether or not they implicate financial institutions and market makers. Exempting these institutions from tax would simply encourage tax-free transactions by and through intermediaries. Such institutions must therefore be taxed in defiance of their important role in market efficiency and stability, which would entail severe efficiency costs.

b. Taxable transactions

Tobin proposes a tax on all “spot transactions” involving foreign currencies. This is likely to be inadequate, as it would invite markets to avoid the tax by trading in financial derivatives. 31/ Substitutability of financial instruments is thus a severe problem for the scheme. Moreover, it would be simplistic to require that both cash and derivative markets be taxed equally. The definition of taxable transactions and their delineation is much more complex than appears at first glance.

The first issue relates to foreign exchange transactions that involve basket currencies (like SDRs or ECUs) and currency indices. Taxing such tools could lead to double-taxation if transactions in underlying currencies are taxed as well. This would discourage the use of these market instruments. But SDRs and ECUs could eventually acquire characteristics of “true” currencies and become important elements in defining world liquidity in the future, in which case they should also become subject to tax. Another issue relates to transactions involving gold as a counterpart. Despite its official demonetization, gold transactions should also be taxed as long as gold serves as a refuge for speculators in times of exchange rate turbulence. 32/

A third problem relates to markets being able to develop (and having developed) close substitutes to cash that eventually escape the tax. The use of short-term market instruments, similar to banker’s acceptances and commercial papers, could become a response of the market if the Tobin tax were restricted to cash transactions only. Equally, foreign exchange market funds and repurchase agreements (against collateral, and not settled on central bank accounts) could emerge as a tax avoidance scheme. Such instruments could also contribute to increasing settlement risks and thus destabilize financial markets.

Money market instruments in foreign exchange should be subject to the tax as they develop. However, it is difficult to define such products in advance. The tax code must therefore establish a tax base in comprehensive terms, which should prevent the emergence of money market instruments as pure tax-avoidance schemes. Their use as genuine financial instruments should, of course, not be inhibited.

Finally, other derivatives such as outright forward transactions, futures, financial swaps, and options should also be taxed, as they permit the transformation of long trading into short trading (e.g., swaps) with important repercussions on spot markets. They allow, for instance, the leveraged mobilization of funds for speculative activities on cash markets. Nearly two thirds of all forward transactions have a very short maturity (seven days or less). 33/ Such transactions have grown rapidly in number and now form an important segment of the foreign exchange market. The swap market is the second largest segment after the spot market, and one of the fastest growing (see Table 3).

Table 3.

Net Foreign Exchange Turnover by Important Currency Pairs in April 1992

(In percent of daily average turnover)

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Source: BIS (1993), pp. 10 and 17; and IMF staff calculations.

However, the problem is not simply resolved by imposing the tax on transactions in derivatives, because the transaction volume cannot be matched with an underlying long transaction in a straightforward manner. For instance, future contracts mobilize funds on a comparatively small capital base and thus operate with very low transaction costs. A Tobin tax on the transaction or on the contract value would grossly understate the value of funds that might be channeled to foreign exchange markets on the basis of such deals, but taxing the notional value of the contract would probably severely damage the market of such instruments and could even destroy them entirely. 34/ Forward and futures markets play, however, an important role in hedging exchange rate risks and their devastation would represent a severe blow for the stability of foreign exchange markets. Similarly, a foreign exchange swap or a combined interest rate/currency swap would be difficult to relate to an underlying “long” financial instrument and to tax it in line with spot market transactions. The same could be said for foreign exchange options. 35/

Campbell and Froot (1993) discuss two principles for relating derivatives to cash market transactions for purposes of taxation: (1) transactions generating the same payoffs (outcome) should pay the same tax; and (2) transactions that use the same resources (costs) should pay the same tax.

Despite its attraction, the equal payoff principle rapidly runs into difficulties. Consider, for instance, two financial products with the same payoff pattern (like a foreign exchange option, and the long-trading in underlying assets that exactly replicates the payoff of the option). The two instruments vary only in their trading intensity. This implies that a uniform tax on financial transactions must disfavor one instrument over the other to the effect that markets will use the more lightly taxed financial product. This is likely to distort the genuine function of such derivatives. Uniform transaction taxes are thus generally not able to equate the tax burdens from trading two instruments with the same payoff as they may differ in trading intensities. “(N)o system of tax rates will enable a government to tax transactions according to their payoff patterns” (Campbell and Froot (1993), p. 18).

The other principle, equality according to resource costs, also runs into problems. One approach would be to impose the tax on transaction costs directly. 36/ The tax would then become a sales tax on financial services rather than a transactions tax as proposed by Tobin. But such an approach would be based on a narrow definition of resource costs, and it would exclude, in particular, externalities that relate to exchange rate volatility, to higher risk premia, to lower levels of investment and foreign trade, and to the misallocation of financial resources. Reduction of such externalities is, however, precisely the objective of the Tobin tax.

Another option would be to tax the notional amounts invested, but at lower rates for derivatives because of their lower costs. This would create a propensity toward a complex system of selective taxation with considerable implementation problems. It would be difficult to calibrate tax rates exactly to market conditions, because elasticities of trading with respect to transaction costs vary significantly among the instruments. They are substantially higher for forward than for spot transactions, but their empirical importance is totally unknown. There is thus no simple general solution that would avoid the discrimination of derivative markets against cash markets, and vice versa. But a system of selective tax rates should be avoided under all circumstances, because it is essentially arbitrary and it involves formidable administrative complexities without ever being bias free.

Summarizing the problems relating to the Tobin tax base, the dilemma has a number of important dimensions. First, it is not possible to distinguish between normal trading and noise trading. Taxing both could harm financial markets without impeding speculation in periods of distress. Second, taxing equal payoffs on an equal footing is impossible with a transactions tax, given that trading intensities vary widely. A Tobin tax must discriminate against various types of financial instruments. Third, the multiplicity of instruments with varying costs would require a set of selective tax rates, which is irreconcilable with the idea of uniformity and universality, and it would constitute an administrative nightmare. Nevertheless, a partial solution could lie in designing a two-tier rate structure with an extremely low tax rate for normal operations, and a high rate on speculative “windfall profits” during periods of erratic trading as further described in Section VII.

2. The tax rate

The problem of setting the tax rate has already been noted in the context of Tornell’s contribution to the Tobin tax. It is linked to the problem of defining the tax base. Tornell argues that an optimal Tobin tax would have to operate with a zero tax rate (or, equivalently, a zero base) when the exchange rate is in equilibrium, and it would increase in accordance with the degradation of equilibrium. The Tornell variant of the tax has either a fluctuating tax base, or variable rates. This is in sharp contrast to Tobin’s original proposal of a uniform tax rate on international transactions. The dilemma of a fixed rate Tobin tax is that a low level of, say, 2 percent on a round-trip transactions is unlikely to deter investors who will expect a short-term devaluation of, say, 5 percent during periods of speculation. And a high rate would, of course, become a serious impediment to efficient financial intermediation.

The dilemma could, again, be resolved through a two-tier rate structure which taxes normal exchange operations only lightly while imposing a high rate on “windfall profits” in the case of speculative attacks. Such profits would become taxable at very high rates, perhaps in the range of 50 to 100 percent. Obviously, this would involve the need to design a tax base that allows discrimination between normal and speculative financial flows. Furthermore, windfall gains associated with speculative financial flows would have to be defined. The proposal is further elaborated in Section VII.

Another case for discriminatory taxation through differential rates results from the need to limit the possibility of funds moving to offshore financial markets not subject to the tax. Of course, bringing all world financial centers under the tax regime would be a matter of negotiation and policy coordination, yet as long as this is unlikely to be successful in the short run, tax discrimination could be used to bring offshore centers to the negotiating table. The history of national securities transactions taxes—where the risks posed by their narrow coverage are even greater than under a Tobin tax which would eventually embrace all the major financial centers of OECD countries—provides examples in this respect. In Sweden, the securities transactions tax rate for funds moved offshore was three times the rate of the round-trip tax on registered equity (Campbell and Froot (1993), p. 7), and the U.K. stamp tax was three times the ordinary rate if shares were transferred to “active nominees” who are allowed to trade tax free on the U.S. stock markets. 37/

3. Tax revenue

The revenue of the Tobin tax would depend on a number of factors, the rate, the base, and exempt trades or institutions. Significant behavioral response to the tax by market participants would be expected, yet extremely difficult, if not impossible, to assess. The higher the tax rate, the lower the taxable base would become (“Laffer effect”). It would thus be adventurous to engage in forecasting the expected revenue of a Tobin tax, particularly because the Laffer effect is likely to be dramatic. Nevertheless, there could be important revenue implications of the tax, because of the sheer size of foreign exchange markets.

As above mentioned, global net turnover in the world’s foreign exchange markets (spot, forward, and derivative contracts) 38/ was estimated to have been some $880 billion per business day in April 1992 (BIS (1993)) and may have approached the level of $1 trillion a day by now. A static revenue estimate (excluding behavioral changes to the tax) for a 1 percent Tobin tax on global net turnover of all spot and derivative markets would thus amount to $10 billion a day or about $2.5 trillion a year (assuming 250 business days per annum). Of course, this figure is totally unrealistic. But even if foreign exchange markets would contract by 99 percent as a response to the new tax, it would still raise the sizable amount of $25 billion. Alternatively, a tax rate of 2 basis points (two hundredths of a percent) could raise the amount of $50 billion (which approximates the annual volume of official government aid to less developed countries). Such a small tax rate would probably entail only moderate behavioral reactions of foreign exchange markets, and the static revenue estimate could be much more realistic. 39/

Nevertheless, market reactions to the tax cannot be disregarded, although it is extremely difficult to quantify them. More generally, behavioral response follows the reduction of the value of currencies by expected future transaction liabilities. These could be estimated on the basis of studies available for securities transactions taxes. 40/ Such results have to be treated with caution, however, because transaction costs may be endogenous. Their measurement could be inaccurate to the extent that they include the price impact of trading and the effects of capital gains taxes which cannot be proxied by a fixed number (Campbell and Foot (1993), p. 22). However, the methodology for assessing behavioral response is, in principle, available.

One possibility for markets to react to the tax is related to its differential impact on vehicle and nonvehicle currencies. Since exclusive trading in vehicle currencies avoids the tax altogether, world financial markets could retract into vehicle currency (U.S. dollar) trading. The second possibility would be to trade less frequently through netting, which is possible with the aid of modern technologies. The third possibility would be to eschew the tax through the forming of monetary blocks like the European Monetary Union. 41/ Some of these options are considered even without a Tobin tax, but the introduction of the tax could speed such processes.

Finally, the question as to who should be entitled to appropriate the proceeds may represent yet another difficulty with the Tobin tax. The potential for revenue raising could simply be too high to assign the tax exclusively to an international organization or to a specific supranational cause.

4. Tax assignment

Tax assignment is a highly controversial political question and cannot be dealt with extensively in this paper. It is clear that a Tobin tax requires international coordination, although it may be administered by national governments. Tobin designates the World Bank and the IMF as possible candidates for coordinating the tax at the international level. 42/ However, it does not follow that the tax proceeds would also be appropriated by the institution that orchestrates the tax.

There is, of course, a legion of alternatives to assigning the tax to the World Bank or the IMF. In particular, tax proceeds could be handed back to national governments. 43/ One possibility would be to apply the derivation principle, which would redistribute the tax proceeds to the countries of origin. This would favor countries with important financial centers, and it is likely to be resented by the rest of the world. It would also lead to an extremely inequitable distribution of revenue, and is likely to deviate from the regional incidence of the tax. Such distribution formulas would be arbitrary in economic terms, and be determined exclusively by historical fortune. 44/ However, tax proceeds could also be redistributed to national governments on the basis of various other distribution schemes like, for instance, the quota ascribed to an international organization. 45/

The basic philosophy behind Tobin’s idea on tax assignment is economically sound, however. Since the regional incidence pattern is difficult to determine, the proceeds should ideally be assigned to a supranational body where they can be used to provide public goods on a global scale. Instead of assigning the tax to an existing institution, it could also be used to serve specific purposes of worldwide importance such as basic research in health, the protection of the environment and habitat, or similar global objectives. 46/

Obviously, solving the tax assignment problem would entail significant international coordination costs of establishing a worldwide consensus. This may become the ultimate pungent question for tax implementation, even if all technical and policy issues are resolved. This is because assigning revenue from the Tobin tax to a supranational body is tantamount to conveying significant power to that institution, which is likely to be resented by some member countries.

VI. Administrative and Operational Issues

Once the tax policy questions have been resolved, in particular the definition of the tax base, the Tobin tax is comparatively easy to administer. This is because its base is a straightforward cash flow transaction (with the reservations made earlier regarding derivatives), there are no substantial exemptions at a personal or institutional level, and the tax rate is uniform and proportional. Furthermore, the foreign exchange market is relatively well structured, and the number of licensed participants is limited: most transactions (70 percent) are effected between registered dealers (BIS (1993), p. 11).

Moreover, transactions take place in a small number of geographical centers. The United States, the United Kingdom, and Japan accounted for 55 percent of all countries’ total reported turnover in 1992. If the next four most important centers—Singapore, Switzerland, Hong Kong, and Germany—are added, about 78 percent of total trading is accounted for (BIS (1993), p. 13)

Finally, foreign exchange transactions all rely heavily on automated processing and on telecommunications networks, which renders tax administration particularly simple. Tax assessment rules could be built into existing computer algorithms, and the collection and enforcement of the tax made automatically at the settlement stage. The focus of tax administration would then be on surveillance and auditing.

Tobin’s idea is to use national tax administrations to assess and collect the tax even though the rules would be fixed at a supranational level. This is feasible if an initial agreement can be reached among the countries with the major financial centers. As stressed before, non-cooperating countries could eventually be encouraged to join the international tax regime if transactions to and from such centers in the regulated core countries are penalized through higher tax rates.

In 1992, in nine countries (including the United States and the United Kingdom), one third of recorded transactions value was arranged through brokers. Another third was arranged through electronic dealing- systems in the United States, and one quarter in the United Kingdom (BIS (1993), p. 23/24). The importance of an electronic system varies greatly among countries, but seems to be increasing. There is also a tendency toward greater market concentration, which facilitates the administration of the tax.

However, complications may arise, particularly from cross-border transactions with nonbank institutions. It would thus become necessary to license all foreign exchange market participants at a supranational level, which would become the legal basis for their being subject to the tax. The licensing must be comprehensive and include banks, brokers, securities companies, fund managers, insurance companies, pension funds, leasing companies, and, eventually, larger commercial firms.

Most foreign exchange transactions have to be settled eventually (with the major exception of options not exercised), which is effected through central bank accounts. Because most deals are wholesale transactions, settlement uses the payments systems of the countries that issue the currency concerned. This is another advantage for administering the tax. It is, however, preferable not to impose the tax at this final stage of settlement. The tax should become due (and payable) when the contract is drawn up, to influence the effective fixing of the exchange rate. This may complicate matters, however, as there is a risk of double-taxation for intermediate transactions (especially cross-border) until the settlement is finalized. But this could be avoided by adding an electronic routing slip to the transaction, which would track the tax record and payment until the transaction is settled on a central bank account. The central bank would be entitled to discount the tax from the amount to be settled and to transfer the amount to the destined institution.

Generally speaking, there seem to be no major administrative problems associated with the operation of a Tobin tax, although difficulties may arise in detail, in particular in the derivatives markets. The main problem relates to international cooperation and legal enforcement in a system that will have to rely on national taxing authorities. The cooperation of national tax administration is, therefore, inseparable from the pivotal role played by the tax assignment question.

VII. A Blueprint for Options

There are not many alternatives to the Tobin tax as a stabilizing device. One option—tax on the domestic stock of foreign assets, not on the flows of foreign exchange transacted, as used in the past by some countries (Germany, Switzerland)—would increase the opportunity costs of holding foreign assets, causing investors to shift into home assets. It is questionable, however, whether a tax on stocks can deter short-run speculation. Such a tax will have a longer-term structural impact. It may also be questioned whether discriminatory taxation of foreign and domestic assets is consistent with the spirit of the OECD’s Liberalization of Capital Markets Code or the GATT.

A second option would be taxes on capital outflows or inflows. Such taxes have been used, for instance, by the United States on capital outflows during the 1960s (interest rate equalization tax) or, more recently, by Israel on capital inflows. Again, these measures have a structural impact, and they are futile as antispeculation tools. They have also been unsuccessful in coping with the underlying structural problems on a more permanent basis, and they are difficult to reconcile with the freedom of capital movements. This may be why they were ultimately abandoned.

A third option would be a sliding scale capital gains tax, which would apply higher rates to short-term capital gains. Such a tax would presumably have to be embedded in national income tax legislation. It is difficult to see how such a tax could be coordinated at the international level. Experience with national withholding taxes on interest income demonstrates that there is little incentive to cooperate internationally for those financial markets that benefit from low or nonexisting taxation on income or capital gains of foreigners. Such a tax would also pose severe administrative problems, because the tax rate would have to vary according to the term structure of capital gains. Furthermore, in a world of integrated information and telecommunication networks, it is increasingly difficult to pin down a locational incidence of capital gains. They can easily be shifted into tax havens.

But, the Tobin tax as a financial transactions tax has a number of attractions. Its base is broad—possibly involving less distortions than more narrowly based taxes. The tax could raise substantial revenue, and it is administratively simple. To render the Tobin tax operational, the design issues discussed in the previous sections will have to tackled, and some will require international coordination and difficult political choice. However, a two-tier rate structure, as outlined in this section, could eventually become feasible.

1. General remarks

As stressed before, stabilizing exchange rates would require high and varying tax rates, which would seriously obstruct the workings of international financial markets. In contrast, a small charge on international financial transactions would hardly cause significant distortions, but such a tax is unlikely to inhibit exchange rate speculations.

One possible solution would be to consider both a low-rate transactions tax plus a surcharge as an antispeculation device, whereby the latter would be triggered only during phases of exchange rate turbulence and based on well-established criteria. The former would function on a recurrent basis and raise substantial and stable revenue without necessarily impairing the normal liquidity function of world financial markets. It would also serve as a monitoring and controlling device for the exchange surcharge, which would be administratively attached to it. 47/ The exchange surcharge would be dormant in times of normal operations of the exchange market and, ideally, raise no revenue at all. It would, however, function as an automatic circuit breaker whenever speculative attacks against currencies occur (if they materialize at all under the regime, which is doubtful). The two taxes would thus be fully integrated, the former tax constituting the operational and computational vehicle for the latter.

2. The underlying transactions tax

A minimal nominal charge on foreign exchange transactions of, say, one basis points (.001 percent) would raise the cost of capital only slightly, but would probably be neutral as to the volume of currencies transacted. 48/ The tax could also be employed on derivative trades, at a standard lower rate of, say, half the standard rate. This would allow derivative markets to continue functioning at low costs, yet prevent the emergence of derivatives as tax avoidance schemes. However, given an approximate net value of about $1 trillion changing hands per business day, the tax would still raise close to $25 billion per year. The tax base remains, however, vulnerable to structural changes in international financial markets, such as the introduction of a common European currency.

If agreement could be reached on which organization is entitled to appropriate this revenue and/or what purposes it should serve, such an international tax could become an interesting option in the future. The organization empowered to implement the tax would license financial institutions and brokers engaging in international transactions and oblige them to administer the tax on its behalf. Administration would be almost costless as it implies only small changes to existing computer programs. It would probably also impose little costs on over-the-counter (OTC) and customer-related transactions, but as the number of banks and business enterprises engaging in foreign exchange is much greater than the number of electronic networks, there would be extra compliance and auditing costs. These could become so high as to render the use of networks more widespread, which is probably the general market trend in the longer run.

The tax would be due in advance before the transaction order can be executed. To prove that the tax has been paid, and avoid double-counting or the discrimination of currency transactions through vehicle currencies (such as the Eurodollar market), an electronic routing slip would be attached to any transaction that contains corresponding tax information until the transaction is finally settled on a central bank account. The routing slip authorizes the settling central bank to discount the tax from the amount to be settled.

The tax would, of course, discriminate against smaller currencies and favor the use of vehicle currencies, since exclusive dealings within one key currency would be tax free. 49/ owever, the incidence pattern of the tax would not differ much from that induced by private transaction costs at present.

As discussed more fully before, a higher tax rate should be imposed on capital transactions with those financial institutions that do not impose the tax and refuse to adopt the international scheme. This would likely dry up the noncooperating offshore markets and tax havens, which would make them reconsider their long-term interests and foster multilateral solutions.

3. The exchange surcharge

The exchange surcharge would be administered in conjunction with the underlying transactions tax, but it would pursue a different objective and function. The objective would be to tax negative externalities associated with excessive volatility per se. For normal operations, the tax would be zero, which would secure the liquidity of the markets and allow efficient trading. Only during phases of speculative trading would the tax be levied, yet it would bite rather hard under these circumstances. It could be confined to cash transactions, yet it could easily be extended to the derivatives market if need be, because derivatives would already be taxed under the transactions tax. Ideally, revenue from the exchange would be nil, if it is to achieve its objective.

There are three possible surcharges: a discretionary tax, a quantity-oriented tax, and a price-oriented tax (“windfall gains” tax).

a. Discretionary tax

Similarly to unilateral monetary defense schemes of central banks today, the tax could be activated by an international organization ad hoc whenever speculative tendencies become apparent. The organization would announce a tax rate (or a set of rates) applying to specific transactions, and the tax policy would be enforced immediately, albeit only temporarily.

Such a discretionary tax has a number of disadvantages. There must be close surveillance of markets, and firm criteria for market intervention would have to be established in advance. Markets would try to anticipate the tax policy, and fiscal response would then always come too late. Also, the activation of the tax through discretionary policy would imply adverse signaling to financial markets, and it must hence provoke and intensify a speculative mood. Furthermore, there would be shocks to the liquidity position of market participants, which could seriously jeopardize the stability of the financial system. Finally, no national parliament would reasonably vest its own government with such discretionary powers, let alone an international organization. The approach should therefore be discarded as a viable economic and political option.

b. Quantity-oriented tax

Rather than activating the exchange surcharge exogenously through a policy decision, it could be switched on automatically whenever the daily transaction volume of a specific currency market transcends a predetermined level. This level could be determined by a crawling peg (like a moving average over the last 20 business days) plus a safety margin in percent. The margins may differ for different currencies, but the same rules would apply to all markets and to all institutions operating in the market. Of course, the shorter the time interval for the crawl, the greater the scope for short-term fluctuations. The interval should, however, be sufficiently short to avoid “leaning against the wind,” and to allow markets to adjust to changes in fundamentals.

Whenever the tax is activated, transaction costs will become significantly higher than before, which should induce markets to smooth out large fluctuations to avoid such costs. Traders would have to be given the right to recontract, however, since the transaction costs involved cannot be known in advance. This would render a significant proportion of contracts contingent, and speculative attacks would become more difficult as traders would automatically withdraw from markets in the case of large volume fluctuations. Ideally, this will lead to markets behaving more smoothly, and the tax would never be activated.

The proposal has a number of drawbacks, however. While quantity fluctuations may be small for the global market, they may be large at the level of regional markets and of financial institutions, and hard to fix for intraday trading. Switzerland, for instance, loses about 90 percent of its normal foreign exchange business whenever there is a bank holiday in the United States (BIS (1994), p. 175); it is therefore difficult to fix the reference point for the peg as well as the margin for “normal” fluctuations. Although the tax could work as an automatic stabilizer, its implementation would meet substantial difficulties in practice.

c. Price-oriented tax

The remaining option is obviously a tax that is price-sensitive rather than reactive to quantity variations. Its philosophy is identical to that discussed for the quantity-oriented tax, except that the untaxed “band” is defined with respect to a price—the target exchange rate. Whenever the effective exchange rate transgresses the band, the difference between the band rate next to it and the effective exchange rate is considered a negative externality and a windfall gain for one of the contracting partners. It would become the direct base of taxation. The idea is more formally explained in Appendix 3 and illustrated in Chart 1 where an effective exchange rate is simulated over 50 periods with a forward-looking moving average as the target exchange rate for each period. 50/ Higher and lower tolerable rates are defined in proportion to the target rate. As long as the daily fluctuations remain within the band, no tax is levied. Once the effective rate moves beyond the tolerable range, the difference between the band and the effective rate (shaded area) is taxed at a high (eventually confiscatory) proportional rate. 51/

Chart 1.
Chart 1.

Illustration of the Working of the Exchange Surcharge

Citation: IMF Working Papers 1995, 060; 10.5089/9781451847994.001.A001

The scheme works quite like the actual exchange rate stabilization mechanism of the European Monetary System. 52/ However, rather than lending support to a weakening currency through interest rate subsidies or sacrifice of valuable foreign exchange reserves, the currency is defended by taxing technically well-defined windfall profits that occasionally accrue to market participants.

Contrary to the Tobin tax, which taxes all transactions without discrimination at the “wrong end” and hence impacts negatively upon normal liquidity trading, the exchange tax only applies to transactions at the “speculative end,” leaving normal trading unharmed. This does not exclude normal traders from the tax whenever they effect financial transactions during phases of exchange rate volatility. But one could argue that such transactions are only partially taxed to the extent that the exchange rate deviates from a targeted rate by a margin, and that even the “normal” trader would create an externality and make a windfall profit/loss to that degree. Moreover, financial markets can be relied on to be sufficiently ingenious and creative as to rapidly develop various types of contingent contracts—similar to currency options today—which allow their customers to hedge against possible tax risks. Contingent claims markets would thus emerge in the spirit of Stockman and Hernández (1988), as discussed in Appendix 2. Most likely, however, markets would adapt to the new situation by smoothing out financial transactions and avoiding currency speculation altogether since the expected speculation gain is automatically curtailed (or even annihilated) by the tax.

4. Unilateral application of the scheme

The scheme described would ideally work on a global scale, like the tax originally proposed by Tobin. It is stressed, however, that the multilateral adoption of the project could entail political costs and that an international consensus would be difficult to reach. The question is therefore whether the scheme could not also be implemented unilaterally by one (or a small number) of countries initially.

A first criticism of such a suggestion could result from the experience of countries that have used (or are using) financial transactions taxes unilaterally, such as the United Kingdom, Germany, Portugal, or Sweden. Such experience demonstrates that transactions taxes have a negative impact on the development of a local financial market, they are highly distortive, and encourage evasion through moving financial operations abroad. However, the same cannot be said for the proposed variant of the Tobin tax. The setting up of a parallel market for domestic currency conversions abroad is costly and will only be profitable if transaction costs are higher at home on a consistent and permanent basis. This is not true for the exchange surcharge. Provided the underlying transactions tax has a very low (or zero) rate, the exchange surcharge itself is unlikely to deter normal financial business because it is evoked only occasionally or, perhaps, never.

Moreover, all transactions in highly liquid home currency would have to be settled on an account with the central bank. This would give the bank the option to administer the surcharge unilaterally and to discount the tax from the total amount settled, even on an asymmetrical basis.

However, unilateral adoption of the scheme could entail complications through the workings of cross-exchange rates. The multilateral scheme could probably define target exchange rates on an autoregressive basis for each pair of exchange rates without interfering with cross-currency arbitrage, provided the bands are appropriately set for the various currencies. A unilateral scheme would probably face such difficulties, however. It is therefore more appropriate to define the target rate relative to a basket of currencies (as in the European Monetary System) and let the market determine cross-exchange rates. However, this could eventually trigger the exchange surcharge whenever the reference currency (basket) is subject to volatility, which cannot be excluded a priori. A unilateral “defense” scheme for a smaller currency would then be invoked, although its fundamentals are unchanged simply because basket currencies exhibit volatility. This would call for a comprehensive basket of currencies to mitigate fluctuations associated with individual “anchor” currencies. While not ideal, the unilateral adoption of the scheme seems to be feasible. This is true in particular for countries that try to peg their currency unilaterally to a vehicle currency like the U.S. dollars.

5. Structural implications of the scheme

Of course, the scheme is unable (like any other short-run stabilizing monetary policy measure) to compensate for structural problems of the currency. Redressing an ailing economy is not the purpose of the exchange surcharge. On the contrary, the scheme allows the smooth adjustment to “fundamentals” by avoiding a leaning against the wind policy. Desirable corrections of the exchange rate are possible as the target rate—the moving average—is allowed to converge to its equilibrium value. But erratic short-term volatility induced by speculation would be reduced through the scheme.

It can be argued that the exchange surcharge could not prevent speculative trading in the case of sudden fear of payment defaults or political crises. Speculative capital would then be withdrawn irrespective of the costs. Again, the surcharge (as any other policy measure including capital controls) is not able to act against “animal spirits” or irrational behavior. Its effectiveness also depends on the tax rate chosen, which could reach confiscatory levels in which case trading outside the band could be stopped effectively. In any case, it avoids the negative effects of alternative monetary policy measures which would sacrifice valuable international reserves or offer excessively generous interest rates under these circumstances. Instead of depleting public assets, the surcharge would raise revenue in such instances. It would also eliminate expectations of recurrent bail-outs by central banks, which would diminish moral hazards and reduce the incidence of financial crises.

Moreover, it can be anticipated that the tax would also stabilize longer-term exchange rate movements, this would work through its impact on investors’ expectations. Although the tax would not interfere with normal liquidity trading among banks nor with transactions motivated by trade or fixed capital formation of international investors, short-run speculative investments might eventually face the partial confiscation of speculative windfall gains once the exchange surcharge is triggered. If investors have rational expectations, this should reduce the scope for short-term speculation against currencies and the capital inflows in countries with weaker fundamentals. Consequently, exchange rates would reflect fundamentals more judiciously. Of course, reduced inflows of speculative capital would lessen the vulnerability of a country because the potential volume of speculative outflows would also be reduced. The term structure of international capital investments would likely adjust to the tax, and the exchange rate would reflect more strongly the impact of longer-term capital movements.

For instance, some Latin American countries have recently benefited from significant inflows of capital, which has strengthened their respective exchange rates and may even have led, in some instances, to an overvaluation of their currencies according to fundamentals. But it is not always possible to determine the term structure of these capital flows, and some of these countries may have been tempted to count on revolving finance, even in the presence of clear short-term investments. This entails severe financial risks in the case of a reversal of trends. 53/ An overvaluation of a currency may then be followed by a sharp depreciation once the speculative bubbles burst. However, the tax, through its impact on investors’ expectations, could eventually avoid such bubbles and keep exchange rates closer to their medium-term equilibrium values.

It can also be assumed that potential distortions in international capital formation and financing decisions would be negligible under the exchange surcharge. Similarly to Tornell’s (1988) tax, the surcharge reduces the variance of the domestic interest rate without changing its long-run expected value, for example, it does not drive a wedge between long-term domestic and foreign interest rates. Its impact on longer-term investment decisions should therefore be neutral.